Tuesday, September 4, 2012

Woodford at Jackson Hole

Mike Woodford's Jackson Hole paper is making a big buzz, and for good reasons. Readers of this blog may be surprised to learn that I agree with about 99% of it. (Right up to the "and hence this is what we should do" part, basically!)

Any student of economics should read this paper. Mike lays out in clear if not always concise prose, and remarkably few equations, the central ideas of modern monetary economics, on all sides, along with important evidence.

Mike's central question is this: how can the Fed "stimulate," now that interest rates are effectively zero, and given that (as Mike reviews), "quantiative easing" seems extremely weak if not completely powerless? He comes up with two answers: (Hint: starting with the conclusions on p. 82 is a good way to read this paper!)
First, the Fed can make promises to keep interest rates low in the future, past the time when normally the Fed would start to raise rates. He hopes that such promises would lower long-term interest rates, through the usual expectations hypothesis mechanism that long rates are expected future short rates. He is sympathetic to "nominal GDP targeting" as a way to commit to those promises.

Second, drop money from helicopters, i.e. "coordinated monetary-fiscal policy." Basically, the Treasury borrows money, writes checks to voters ("helicpoters"), and the Fed buys the debt. I certainly agree the latter policy can create inflation (I wrote as much in "Understanding Policy"), though both Mike and I emphasize that policy needs some expectations and commitments asterisks too.

Why monetary stimulus?

One reason I disagree so little with the analysis of this paper is because of the part that Mike left out (rightly, it's already 98 pages): Mike didn't explain why he thinks more monetary "stimulus" is a good thing right now.

Treasury rates are at 50 year lows. The 10 year Treasury rate is 1.5%. At 2% inflation, that's a negative 0.5% real rate. Yes, the economy is in the toilet, but surely too-high Treasury interest rates are not the crucial economic problem right now.

So the case for "stimulus" must be that some other, unstated lack of "demand" is the problem, and that all "demand" is the same so that monetary "stimulus" will cure that problem. I disagree on that one.

Mike's enthusiasm for deliberate inflation is even more puzzling to me. Mike uses the word "stimulus," never differentiating between real and nominal stimulus. Surely, we don't want to cook up some inflation just for its own sake -- we want to cook up some inflation because we think it will goose output. But why? Why especially will increasing expected inflation help? Because that is the aim of all the policies under discussion here -- promising to keep rates low even once inflation rises, adopting "nominal GDP targets," helicopter drops, or similar policies such as raising the inflation target.

I don't put much faith in Phillips curves to start with -- the idea that deliberate inflation raises output. I put less faith in the idea floating around Jackson hole that a little inflation will set us permanently back on the trend line, not just be a little sugar rush and then back to sclerosis.

But it's a rare Phillips curve in which raising expected inflation is a good thing. It just gives you more inflation, with if anything less output and employment.

So, in my view, the problem isn't overly tight monetary policy. The economy's problems lie elsewhere. Monetary policy is basically impotent. And it's hard to see that deliberate monetary "stimulus" via expected inflation will help the real economy. We should be telling the Fed to stop pretending to be so all important. You've done what you can. Thanks. You'll do best now by sitting on your hands and letting others cure the real problems. But that kind of advice doesn't get you (me!) invited to Jackson Hole! The Fed wants to "do more."

So, let's leave alone the question whether a bit of deliberate inflation is a good thing -- I think not, but that's where we disagree -- and analyze Mike's proposals for how the Fed can create some inflation. Here I mostly agree, with a few asterisks.

Open mouth operations

So, interest rates are stuck at zero. Can the Fed do anything about it? Many economists have advocated promising that rates will stay at zero further in the future. I've been a bit sceptical of this advice, for example in" Understanding Policy"

I read this move as sign of desperation. Teddy Roosevelt said to speak softly but carry a big stick. These steps
are speaking loudly because you have no stick. What will the Fed do if it announces a higher target but inﬂation does not
change? [Announce a larger one still?] We are here in the ﬁrst place because the Fed is out of actions it can take. Talking is the ‘‘WIN’’ (Whip Inﬂation Now)
strategy that failed in the 1970s.

More generally, I'm skeptical of the idea that wise governance consists of "managing expectations" by government official's promises.

Mike starts with a review of the literature that studies whether announcements -- "open mouth operations" have had effects in the past. Here's a good example.

These are "Intraday OIS rates in Canada on April 21, 2009. The dotted vertical line indicates the time of release of the Bank of Canada’s announcement of its “conditional commitment” to maintain its policy rate target at 25 basis points through the end of the second quarter of 2010."

On many occasions Fed announcements, coupled with no actions, do move markets. Monika Piazzesi and I once looked at high-frequency data and came to the same conclusion.

But these what do we make of this fact? They certainly do not mean that the Fed can talk down rates at its pleasure. Mike briefly acknowledges one possibility: Markets do not interpret these announcements as changes in policy, or "intentions" but instead simply inform the markets of the Fed's deteriorating economic forecasts. If the Fed gets news, or forms an opinion, that the economy will be weak, then future interest rates will be lower even if the bank follows the same old Taylor rule. We can see this reaction even if the central bank has no influence at all over market interest rates (as in Gene Fama's latest) but has a decent forecasting shop. A coming recession means that interest rates will fall no matter what the Fed does about it, so long term rates fall now. Mike has a long section on open mouth operations that don't work, or go the wrong way, and pages of advice for central bankers on how to move markets the way they want.

Mike makes an excellent point though. Overnight rates last overnight. If the Fed has any influence at all on long-term rates, it is entirely through expectations. Talk may not matter, but expectations are everything.

Promises, Promises

Assuming that the Fed does have total control over short term rates, the answer to my Teddy Roosevelt quip is this: Yes, the Fed is powerless to do anything now. But the time will come that the economy recovers or inflation breaks out, and the Fed will want to raise rates. Those 1.5% 10 year rates reflect expectations over some paths in which short rates rise. If the Fed can credibly promise not to raise short rates, even in circumstances in which it would normally be expected to do so, then by expectations hypothesis logic today's 1.5% ten-year rate will decline, as will the implied 10 year real rate (we're assuming the Fed can hold short rates at zero in the future despite the outbreak of significant inflation.)

The deep, intractable problem with this idea is commitment. This occupies the bulk of Mike's analysis, but I don't think he, or others advocating these policies, successfully solves it.

Every day I promise that tomorrow I'm not going to have dessert. Every tomorrow I change my mind. Because I can. Tomorrow, if inflation breaks out, the Fed will want to raise rates sharply.

How can the Fed promise today to do something it will very much regret tomorrow, and get people to believe that promise? More deeply, how does the Fed commit to allowing "just a bit" of inflation in the future, and not starting down the path of the 1970s again?

Here (p. 42, 44) Mike comes out in favor of a nominal GDP targets. In his view, they're not as good as the optimal policies he and Gauti Eggertsson have calculated, but clarity and communication are important, and Mike can see that nobody but he and Gauti understands the optimal policy.

Nothing communicates like a graph. Here's Mike's, which will help me to explain the view:

The graph is nominal GDP and the trend through 2007 extrapolated. (Nominal GDP is price times quantity, so goes up with either inflation or larger real output.)

Now, let's be clear what a nominal GDP target is and is and is not. Many people (and a few persistent commenters on this blog!) urge nominal GDP targeting by looking at a graph like this and saying "see, if the Fed had kept nominal GDP on trend, we wouldn't have had such a huge recession. Sure, part of it might have been more inflation, but surely part of a steady nominal GDP would have been less recession." This is NOT what Mike is talking about.

Mike recognizes, as I do, that the Fed can do nothing more to raise nominal GDP today. Rates are at zero. The Fed has did what it could. The trend line was not achievable.

The point of a nominal GDP target to Mike is this: When and if inflation breaks out (which raises nominal GDP) or (let's hope) real GDP starts growing again, the Fed, following the usual Taylor rule linking interest rates to GDP growth or inflation, would normally raise rates. If the Fed instead changes to a nominal GDP target, then the Fed will not raise rates, until the cumulative inflation or real growth brings us back to the dashed line. Then, and only then, will the Fed raise rates.

And, it will (supposedly) use all its hard-won anti-inflationary toughness to keep nominal GDP (inflation at that point) from growing faster than the trend line. In fact, it will become super-tough. In the past, with an inflation target, the Fed swallowed inflation shocks. With a nominal GDP target, the future Fed will supposedly commit to a slow deflation after a 1% surprise inflation shock, to bring the level of nominal GDP back, just as now it is committing to a substantial inflation to bring up the nominal GDP level.

In sum, this nominal GDP target discussion is not about what the Fed does now, or what it should have done in 2008. It is not about whether over the long run a nominal GDP target is better or worse than a Taylor rule (roughly, its first difference), which is a good topic for another day. It is a proposal to manage expectations about what the Fed will do in the future, and its hope is to lower long-term rates now.

Sounds good? Not so fast. Odysseus had himself tied to the mast so he could not change his mind. The Fed is changing rules now, in response to extreme conditions. What stops the Fed from "changing rules" again, the minute inflation does break out? True precommitment means setting things up so you can't change your mind, or at least so there are substantial costs to changing your mind. When Woodford 2016 comes back to Jackson Hole saying, "to fight this galloping inflation we need to change to the Gold standard rule" what stops that?

"Rules" without costs are no better than promises. I don't just promise each day not to have dessert. I change each day to the "no dessert" rule. Each night, I change back to the "no dessert, starting tomorrow" rule.

Furthermore, people might be less worried about the tough anti-inflation Fed than the new we-want inflation Fed. The second promise of the nominal GDP target is to contain expectations that once inflation breaks out it explodes. One inflation breaks out, and the Fed isn't responding, will people really say "oh, that's the new nominal GDP target Fed, they'll get really tough once we get to the 2007 nominal GDP trend?" Or will people think "oh-oh, we've got the 1970s Fed on our hands again"!

Suppose it's 2016, inflation has brought nominal GDP to
trend, but real growth is still stagnant, unemployment is still high,
the eurozone mess is worse, and candidate Hilary Clinton's poll numbers
are tanking. Will Mike--and maybe more importantly, Christina Romer,
Paul Krugman, Brad Delong, and the rest of the dovish punditry recently converted to nominal GDP targeting -- really stand up and say, "we're on the nominal GDP
target. We have to keep our promises. Raise rates and open the bar
early."? More importantly still, do people now believe that will happen?

(There is also a larger question here, why do we that people will believe fine-tuned promises from the Fed about some brand new, never-tried rule, about how it will behave 5 years from now. To the public, how are the Fed's promises different from annual rosy scenario budget forecasts out of every Administration? How many average Jay-Walking voters even know who Ben Bernanke is or what nominal GDP is?)

I think the lesson of all precommitment economics is, that if you want people actually to believe the commitment, it must have substantial costs to change. Making the target a legal restriction might do. But the Fed adamantly doesn't want any restrictions on its power.

If you cannot limit your power ex post, you cannot commit to anything ex ante. If you cannot commit ex ante to do things you will not want to do ex post, your promises are empty. Even if they are "rules" not "actions."

Mike beautifully sums up what we're looking for on p. 82,

Central bankers confronting the problem of the interest-rate lower bound have tended to be especially attracted to proposals that offer the prospect of additional monetary stimulus while (i) not requiring the central bank to commit itself with regard to future policy decisions...

That criterion dooms a nominal GDP target or any other promise that is not "forward-looking" or "discretionary."

Especially the Fed. Institutions work from historical perspective, and the Fed regards itself as fresh from the great success of "unconventional" policy experimentation in the great crash of 2008. What, tie ourselves to some rule that might keep us from saving the world again with our innovative discretionary policy? Not a chance.

(And even a legal restriction, writing nominal GDP targets into the law, is no guarantee. The ECB has a legal restriction against buying sovereign debt. Ha Ha Ha.)

The Fed was an alcoholic in the 1970s. It went on a 12
step program, reformed in the 1980s, and not it's a teetotaler on
inflation. It wants to promise to go back to being a social drinker --
just three drinks until my nominal alcohol target is fulfilled for the
night. And it doesn't want to let its spouse pour the drinks.

Quantitative easing

Mike moves on to quantitative easing. Here, the Fed buys short term treasuries, long term treasuries or other securities, issuing money in the process. Does this "stimulate?"

Mike starts (p. 49) by masterfully destroying the theoretical idea that QE should work. Yes, monetarists think the quantity of "money" matters, even at zero interest rates. They believe that because they think velocity is stable. The historical experience behind that conclusion does not have long periods of zero rates. When interest rates hit zero,

the demand for reserves should become inﬁnitely elastic, so that variations
in the precise quantity of excess reserves (as opposed to other short-term, essentially
riskless assets) that banks must hold will have no consequences for equilibrium determination. ...once that lower bound is reached, further
expansion of the supply of reserves should not have any consequences for aggregate
expenditure or the general level of prices (or for that matter, for broad monetary
aggregates).

Mike goes on to skewer long term bond purchaes -- they are the same as ineffective QE plus a rearrangement of the maturity structure of debt, which at least should not involve the Treasury doing the opposite.

Starting on p. 60, he points out that no asset market purchases should have any effect. If the Fed buys mortgages or long term bonds, yes, the private sector seems to hold less risk. But the Fed is ultimately holding risk that is guaranteed by the Treasury and hence by your taxes -- The Modigliani-Miller theorem of Fed impotence. The starting place should be that purchases have no effects.

Of course there are frictions, liquidity effects, and so on. But with this theorem, all monetary theory must be about really understanding the frictions. (I did say this is a great review of monetary theory! Students, pay attention to these sections) For example, the monetarist position that only the issuance of money matters, but what assets the Fed buys do not matter, comes from recognizing one and only one friction, the necessity of money for making transactions. Mike reviews all the currently hypothesized frictions underlying asset purchases. Go read.

Though Mike goes for frictions a lot more than I do, we end up at the same place: a logical conundrum. If the Fed can affect, say long-term treasuries because that market is segmented, cut off from, say, mortgage markets, practically ipso facto changing long term treasuries won't spill over into markets you care about such as mortgages

Second, the existence of market segmentation makes it possible for central-bank
purchases to affect the price of an asset, but at the same time limits the generality
of the effects of a change in that particular asset price on the rest of the economy.
In order for the policy to be judged effective, it is necessary that inﬂuencing that
particular asset price can be expected to achieve an important aim. In the case of the
CPFF, this presumably was the case — only the ﬁnancing costs of a particular narrow class of borrowers were affected, rather than ﬁnancial conditions more generally,
but the program achieved a speciﬁc goal that motivated its creation. One cannot,
however, point to such a program as evidence that purchasing any kind of assets
eases ﬁnancial conditions generally. Instead, to the extent that market segmentation
is relied upon as the basis for a policy’s effectiveness, one should expect the effects
to be relatively local, and the composition of the asset purchases needs to be tailored
to the desired effect.

Well, if it makes no theoretical sense, maybe it works anyway? Mike's graph here

is better art than the graphs I made in a QE oped here. QE is supposed to lower interest rates. You have to tie yourself in knots to get this graph to say that interest rates are lower in the grey periods when the Fed is buying lots of stuff.

The Fed and its defenders do: they point to the declines in rates just before QE episodes as evidence for QE's power, then point to the rise in rates as verifying that the economy got better. Mike explodes this view deliciously (p.71). The view that only the announcement-day decline measures the effects of QE relies on efficient markets. And if markets are efficient, then QE doesn't work, because it relies on segmented markets.

Mike concludes with an interesting observation: the only way that it makes sense for QE to have any effect is not directly, but because it signals to markets just how desperate the Fed thinks the situation is, and therefore communicates that interest rates will be zero for a long time.

But that makes no sense (p.84 of the conclusion is quietly devastating on this widespread view.) QE has the same commitment problem. The only hope for it to work is for people to think the money will stay out there once interest rates rise above zero. But the Fed has loudly told us how easy it will be to soak up all this money the minute it needs to do it, which is reassuring for inflation. But the point was to stoke inflation!

Helicopter drops

So, in conclusion (p. 82 -- hey, at least the blog post is shorter than the paper!) Suppose the Fed wants some inflation, what should it do? The only thing that can create some inflation, if the Fed wants to do that is helicopter drops, which are really fiscal policy: (p. 87):

the most obvious recipe for success is one that requires coordination
between the monetary and fiscal authorities. The most obvious source of a boost to
current aggregate demand that would not depend solely on expectational channels is
fiscal stimulus—whether through an increase in government purchases, tax incentives for current expenditure such as an investment tax credit, or subsidies for lending like the FLS.. At the same time, commitment to a nominal GDP target path by the
central bank would increase the bang for the buck from fiscal stimulus, by assuring
people that premature interest-rate increases in response to rising economic activity
and prices would not crowd out other types of spending than those directly affected
by fiscal policy. And the existence of the central bank’s declared nominal GDP
target path should also limit the degree of alarm that might arise about risks of
unbridled inflation when special fiscal stimulus measures are introduced.

The Treasury borrows and, with Congress, spends the money. The Fed buys the debt and issues money. That's how we do helicopters today.

Even helicopter drops aren't easy however. If people think that the government will raise taxes tomorrow to pay back the debt, and the Fed will unwind the purchase, even helicopter drops don't cause inflation. There really is no escape from "expectations." Helicopters -- or boondoggle stimulus projects -- are thus a communication mechanism for the government to say, "no, we are not raising taxes to soak up this debt. We really are leaving the money outstanding so it will inflate. You'd better spend it fast." And that's just what Mike wants, more "spending." (See "Understanding Policy" for more).

But Mike is being inconsistent here. He told us how impossible it is to commit to a nominal GDP target. And he told us how irrelevant the maturity structure of goverment debt is. Not raising taxes is really a fiscal commitment not a monetary one. Why is Mike back to a costlessly chageable promise to target nominal GDP? I think he recognizes that the commitment not to undo the helicopter drop is crucial to his proposal, and so he has to rescue that somehow.

So, in the end, I find Mike and I in strong agreement on mechanics. IF the Fed wants to inflate, a helicopter drop is the only way to do it. Even that is about expectations. And it's essentially fiscal policy. And, of course, we have now arrived at a point that
completely contradicts the intial search: A policy of announcements,
open mouth operations, that the Fed can follow alone.

The question, which Mike does not address, is this: Why in the world would such a deliberate inflation -- which in this case is a deliberately-induced flight from US government debt, exactly what Europe is so desperately trying to avoid -- be a good idea right now?

The rest of p.82 is chilling really. It is a lovely statement of the Fed's problem:

Central bankers confronting the problem of the interest-rate lower bound have tended to be especially attracted to proposals that offer the prospect of additional monetary stimulus while (i) not requiring the central bank to commit itself with regard to future policy decisions, and (ii) purporting to alter general financial conditions in a way that should affect all parts of the economy relatively uniformly, so that the central bank can avoid involving itself in decisions about the allocation of credit. Unfortunately, the belief that methods exist that can be effective while satisfying these two desiderata seems to depend to a great extent on wishful thinking

We saw how (i) dooms open mouth operations, and conversely dooms the chance the Fed can affect the economy by announcing any new rules and targets.

Yet the Fed wants to be powerful. That leaves (ii). "Allocation of credit" means lending to particular favored markets and institutions. The Fed understands the huge danger of going here. Lending to cronies is how central banks operate in all the basket cases of the world. But, if the Fed is unwilling to say "Inflation 2%. Banks steady. Interest rates zero. We've done our job," and wants to stay powerful, direct lending (which is really fiscal policy) or direct intervention in the policies of the TBTF banks under its control is going to be increasingly attractive.

41 comments:

Your claim that no one has a model in which raising expected inflation is a good thing is a little puzzling. If you look at Woodford's own papers, or at any paper discussing the New Keynesian phillips curve, and you will find an equation showing that raising expected inflation leads to higher output. Moreover, at times when the economy is stuck at the zero lower bound, this is usually the only way in which monetary policy can raise output in New Keynesian models.

There is no commitment problem when you commit to do what you will want to do anyway. Committing to not tighten after a supply shock doesn't raise Odysseus-issues. Perhaps tolerating inflation in a "picking up slack" environment is similar. Committing to allow some reflation is merely communicating that the Fed sees slack and expects that tightening early would harm real output. So long as signs don't lead them to change view on output gap, there's no commitment issue: they won't, and shouldn't, want to tighten while slack is unwinding. Remobilizing idle resources takes time, and behaves like a supply shock.

"What stops the Fed from "changing rules" again, the minute inflation does break out? ... When Woodford 2016 comes back to Jackson Hole saying, "to fight this galloping inflation we need to change to the Gold standard rule" what stops that?"

A constitutional amendment.

"Yes, monetarists think the quantity of "money" matters, even at zero interest rates. They believe that because they think velocity is stable."

That is what Mr. Friedman taught us in Soc Sci I. The late 70s showed that he was wrong in that particular. Velocity is now an infinitely adjustable parameter limited only by the speed of light.

"the Fed buys mortgages or long term bonds, yes, the private sector seems to hold less risk. But the Fed is ultimately holding risk that is guaranteed by the Treasury and hence by your taxes"

I believe that I am the only person in the country who is perturbed by the fact that the Fed is carrying 2.8T$ on 55G$ of capital, an asset/capital ratio of more than 50:1. if the Fed were a bank regulated by the Fed, It would be put into receivership.

I believe that I am the only person in the country who is perturbed by the fact that the Fed is carrying 2.8T$

Apparently you and Prof. Cochrane are the only people who never read Tai-Pan.

In the novel the Struans' notes are called, so that load a vessel with silver and go meet their creditors. Of course, they let every pirate in the world know. The creditors are forced to renew the Strauns notes because they cannot defend the silver from the pirates.

Now, the point of the story is that, when the Feds notes become due, the Fed will offer to either renew them or send you brand new Franklins, shrink wrapped on pallets, by a Fed Ex Plane, giving the creditor the dilemma of what to do with all that cash. If the moment you describe ever happens, the Fed will be very happy if the creditor wants to spend such.

We have the opposite problem. Today, the world has an unlimited demand for safe assets, and there is no reason that such is ever going to change in our lifetimes.

This is Cochrane's microfoundation problem. He imagines a world of horrors, he just cannot explain how it could happen. How, for example, are all the reserves on the balance sheets of all our banks going to get into the hands of private borrowers. Do you think banks are going to open tomorrow and suddenly roll out several trillions in loans?

Ask yourself, under what circumstances, if you had real money, would you want to own any security other than T-bills, notes, or bonds, in today's world?

You forget that his bonds were only payable in dollars which were silver, not gold coins, and that silver was readily available as a commodity, so available that we left the silver standard in the 1870s.

You also need to read up on the Sante Fe trail, by which millions of ounces of silver flowed to the United States through St. Louis from New Mexico, all of which Hamilton foresaw

In sum, he had confidence that he could always pay his bonds with "printed" or perhaps better "coined" money

Mr. Bernanke is not concerned about paying his bonds, save an attempt by the GOP to cause the Lesser Depression to continue.

Woodford clearly claims that an expected increase in nominal GDP growth in the future, whether it is due to higher inflation or higher real output, will raise spending on output now, and either result in higher current real output or higher inflation.

The statement that Woodford agrees with you that it can have no effect on spending now is false.

Also, if you think that the "phillips curve" is that higher inflation causes lower unemployment, then it is no surprise you are confused. The actual argument is that higher spending on output leads to higher inflation and higher output growth and higher output growth leads to higher employment growth and lower unemployment. Given the growth rate of spending on output, the more of it that is inflation, the less of it is real output growth and the higher will be unemployment.

In other words, adverse aggregate supply shocks lead to higher inflation and higher unemployment and that includes an expecational shock of higher inflation.

The mood has changed in this country. You will have to have rampant inflation to get people to deplete their savings then borrow to spend. More inflation than we have now but not too much more will cause people and companies to save more. High enough inflation to make people change will bring its own problems and the whole discussion on this blog changes to that problem.

I totally agree that nothing the Fed does will change expectations, for 99% of Americans believe they are screwed, regardless of what the Fed does. That distrust wisely starts with people like this blog, who are solely concerned with the 1% and then builds and builds.

The power of this expectation can be seen in why Obama goes nowhere. The reason is that his actions have not matched their expectations. Specifically, when he had the votes and could have done something about Jobs, Jobs, Jobs, he screwed them, in their view, with Obamacare, which was the truly the right idea at the wrong time. In sum, with good reason, the American public trusts no one. Romney is also proof. Look at all the pledges he has had to sign to the right wing. That is because they don't trust anyone, either.

To suggest that inflation will change public attitudes is madness.

All these economists are men with hammers. They talk about the Fed cause they got nothing else. Events have proved them totally useless so that argue with each other trying to maintain relevance. None of them have any idea what to do so but they are not about to admit such.

It is very plain we are in a very bad place with private debt at levels that needs to be cancelled and written off, probably by 50%. That is what Bernanke should do. Buy student debt and forgive it all. Buy all our home mortgages and forgive 25%, across the board. Then use inflation to pay back the bonds sold to buy the debts cancelled.

There is plenty of historical evidence suggesting the cancelling of debt does not stop investors from taking the risk again. Everyone has a price; or yield I should say. This is exactly what sovereigns and banks do all the time.

However, if the people were aware of this common practice among gentlemen then the party would no longer be a VIP event. Hence the opposition to write-offs. Why do that when you can force the taxpayers to foot the bill while the technocrats keep playing high stakes poker. I advocate to anyone >15% underwater on their mortgage to walk away. It is a sound business decision plain and simple. It makes even more sense if you are in sound financial condition with the current set of investment opportunities at these yields.

Eventually, the banks will come hollering for you to borrow money because of your liquid situation. Especially compared to those who are underwater. There is no need to wait for technocrats to give the green light. Start beating them at their own game today.

You will have to have rampant inflation to get people to deplete their savings then borrow to spend.

I don't that if the Fed triggered inlation, it would lead anyone to spend more money. If anything, I see that it would be create a negative shock for US growth.

If the US runs higher inflation than other advanced economies without higher concomitant real growth, or real interst rates, US assets flow. Or overseas assets currently invested in the US return home.

This will lead to an exchange rate adjustment, lower investment, lower growth, and eventually higher rates to stablize the situation.

Prof. Cochrane states that, "Nobody will ever save or lend again if we do that."

First, according the Bible there was a 7 year debt jubilee and people lent again.

Second, bankers used to wait for people as they walked out of bankruptcy court with a fresh start.

I could go on, but that really is a superficial response.

My two cents has consistently been that "Nobody will ever save or lend again if we do" what he wants or if we do Martin Wolfe first advocated, the Helicopter drop.

My repeated position has been that our situation is far worse and requires both a profound change in the re-thinking of the national government, a revilization of the national government to make it effective equivalent to the pitching of the Articles of Confederation for the Constitution and economics cleansed of 60 years of pitiful effort. On other blogs you have economists still unable to define money and finance, living in some Hayekian dream world.

If we are not going to do that, then I favor a debt jubilee for our young people through cancelation of college debt. They will then have a chance to put their lives together.

You are correct, I am very unlikely to advocate a 50% cancellation of all debts and massive inflation. Nobody will ever save or lend again if we do that.

Prof. I did not advocate a direct cancellation of student and mortgage debt. I advocated that the Fed buy such debt and then cancel all student debt and part of the mortgage debt.

Now this plan would not hurt any lender.

In fact, it would do exactly what everyone, including you, have advocated for it would hold lenders harmless from their own bad decisions, which would only encourage lending.

In sum, what I am proposing is that the Fed attack directly the underlying problem we have in the modern economy: we do not write off our bad debts fast enough. Instead of pretend and extend, which should find a mechanism that writes off bad debt the moment it appears.

Our lenders are no better today than when lenders in the Old Testament were so bad at lending that a debt jubilee was necessary.

You just cannot invert.

This is one of those paradoxes, like thrift, that the Chicago school does not understand. If you want to encourage only the making of "good loans," you permit only non-recourse loans.

We permit bad lending and ought to "man-up" about it. To believe that we can go such, on the scale we permit bad lending, and not pay more attention to prompt write-offs, that likely is the source of our current woe (and high oil prices)

The SBA loan guarantee program encourages lending, for example, because of the put feature of the program.

There is a second similar program that the Fed could undertake and that is to pay off maturing obligations with cash as well. In sum, everyone always talks about micro-foundations. The Fed has a way of getting cash directly into the economy and that is to print up billions in Franklins, put them on pallets and shrink wrap them, and send them back in the empty containers that liter our landscape.

IOW, when the World demands safe assets, that is the time to instead give it cash. The Tai-Pan knew what he was doing and we should learn from him.

"If the Fed can credibly promise not to raise short rates, even in circumstances in which it would normally be expected to do so, then by expectations hypothesis logic today's 1.5% ten-year rate will decline, as will the implied 10 year real rate"

Not if the policy works. The point of the promise is to immediately create more inflation and real growth, which is consistent with a higher Fed Funds rate. So long term (risk-free) yields should increase, not decrease.

"If people think that the government will raise taxes tomorrow to pay back the debt, and the Fed will unwind the purchase, even helicopter drops don't cause inflation."

Here's the assumption that is violated in reality that gets you some traction with asset purchases (pg 62):

all investors can purchase arbitrary quantities of thesame assets at the same (market) prices, with no binding constraints on the positionsthat any investor can take, other than her overall budget constraint.

My point is this, imagine a 2 agent economy where agent 1 holds all the bonds. Agent 2 has no assets and can't go short - he conusmes all of his after tax income and can't borrow because he has no assets and all borrowing is fully collateralized in this world.

The fed buys a dollar worth of bonds from agent 1. Now effectively agent 2 is exposed to a fraction theta of the risk of the bond, presumably theta is less than a half but it's also greater than zero. Agent 2 can't hedge this risk as that would require shorting the bond. Agent 2 also get's theta of the return of the bond but didn't want to reduce today's consumption to buy that risk/return payoff so is unhappy and would like to hedge.

Agent 1 is exposed to (1 - theta) of the risk/return but was happy with the full dollar's worth so, at the original price, is only happy selling (1-theta) dollars of the bond. Thus, unless the bond's price rises a bit agent 1 uses his new dollar to buy back a bit of bond.

So, the Fed purchase will have some effect on the price. Bigger theta, bigger effect.

"Second, drop money from helicopters, i.e. "coordinated monetary-fiscal policy." Basically, the Treasury borrows money, writes checks to voters ("helicpoters"), and the Fed buys the debt. I certainly agree the latter policy can create inflation (I wrote as much in "Understanding Policy"), though both Mike and I emphasize that policy needs some expectations and commitments asterisks too."

I thought this would be illegal without enabling legislation. So, really, wouldn't the "coordination" involve not only Treasury and the Fed, but Congress as well? How realistic would that be?

Another thought on this. Have we not already had a helicopter drop (or drops)? In mid-2008 Congress approved a tax rebate plan that resulted in Treasury sending checks to most American taxpayers. Then, we had Congress extend the Bush tax cuts which resulted in Treasury sending larger checks to most taxpayers than what they would have otherwise gotten. Treasury had to borrow funds to finance this. More or less at the same time this was occurring, the Federal Reserve started buying up mortgage backed securities and then US Treasury obligations.

The only element that seems to be missing here from the definition of a "helicopter drop" is the supposed lack of "coordination". Yet, who is to say that there was no "coordination". And, effectively, would "coordination" really be an essential element if these things happened simultaneously, as the above events more or less did?

"You are correct, I am very unlikely to advocate a 50% cancellation of all debts and massive inflation. Nobody will ever save or lend again if we do that."

there doesn't need to be MASSIVE inflation Just a return to the previous price level before the crash. And You do agree that inflation helps reduce the burden of debt right Professor?

On a somewhat separate note, I cannot BELIEVE you think the Fed is poweless. I would love to hear your answer to this question? What would happen, in your view, If the Fed bought the entire national debt up?

Would it create:

A Hyperinflation.

B Recovery.

C Above average inflation AND recovery, but not hyper inflation (Something like 20% nominal gdp grwoth with 10% inflation and 10% real growth)

or

D. Absolutely nothing.

Let me try and understand you correctly, Are you saying D? Because even with the first three choices, The actions of the Fed will affect SOMETHING! Its one think to argue the classical view. (printing money affects prices only in the short and long run) its another to say the Fed is powerless to do ANYTHING, which seems like, (I'm sorry) an absurd opinion

Treasury rates are at 50 year lows. The 10 year Treasury rate is 1.5%. At 2% inflation, that's a negative 0.5% real rate. Yes, the economy is in the toilet, but surely too-high Treasury interest rates are not the crucial economic problem right now.

So the case for "stimulus" must be that some other, unstated lack of "demand" is the problem, and that all "demand" is the same so that monetary "stimulus" will cure that problem. I disagree on that one.

This is good rhetoric, but I don't find it very convincing. What gives you such an exact sense of the equilibrium real interest rate? Extrapolation from the historical record, as you do here, doesn't accomplish much; there are regime shifts all the time, and the fact that a certain price generally fell within certain bounds in the past doesn't mean that it will in the future. I think there is a very convincing case that a large shift in the real interest rate is necessary to equilibriate the economy. The financial crisis, unemployment, and resulting uncertainty (including, yes, government-induced uncertainty) have caused consumers and businesses to be far more reticent to spend and invest than in the past. Due to various real rigidities, a decrease of a few percentage points in the real interest rate doesn't increase demand by as much as a simple model might imply, particularly since one margin that is usually highly elastic (investment in structures) is current dysfunctional. This means that an even lower interest rate is necessary to bring supply and demand back into balance. (Conceptually, there is nothing fancy here: this is fairly standard Walrasian intuition.)

Let's imagine a different situation. Suppose economic policy hasn't improved since the 70s, and we still have price controls. Some supply or demand shock causes the price for oil to skyrocket and hit a price ceiling, and we see widespread shortages. Many economists rightly blame the price ceiling for the shortages, and argue that we should increase or do away with it. Yet some left-wing economists say "Oil prices are at all-time highs. The spot price for Brent is $140. Yes, the oil market isn't working, but surely too-low price caps are not the crucial market problem right now." Of course, this argument is clearly wrong -- but to be honest, I'm not sure that it's much worse than your statement above. Both you and my hypothetical left-wing economist are using the fact that a price is outside its historical range to argue that it can't possibly be important to let the price move any further.

Of course, the awkwardness of monetary policy is that the central bank is always controlling the nominal interest rate -- unlike the situation with oil price caps, there's no simple "get rid of the caps" free-market solution. Instead, we need some policy (possibly a rule, possibly not) that responds to various market signals so that the real interest rate comes as close as possible to the ideal Arrow-Debreu intertemporal price. This policy can take many forms -- some kind of inflation or nominal GDP target, a Taylor rule, etc. -- but whatever it is, I'm pretty sure that it doesn't involve handwaving about how historically low yields shouldn't go any lower.

It's interesting that you essentially agree with Krugman as well as Woodward that QE is unlikely to help much, and also share Krugman's scepticism that the Fed really can credibly promise more inflation. That said, it is surely the case that more inflation in and of it self, were it possible for the Fed to engineer it, would help create more demand in the current economy for the simple reason that many of the home owners whose mortgages are underwater would be above water again. If rates could be kept low for a short time, this is turn should allow for a turnaround in the moribund home construction industry. As for helicopter drops, rational people just don't expect to pay all of the extra taxes in the next few years, and with 30 year rates at 2.7% I can't think of any reason why they would. They carrying cost on a trillion dollar loan is $30B/year which is small change in a $14T economy.

Could the Fed simply print money and hand it over without the Treasury selling it debt? That would more credibly indicate that the monetary base was permanently expanded and that taxes would not be raised to pay off the debt (which wasn't really "borrowed" in the first place).

Another thing: there can be a possible commitment problem if one rule is best in some situations, and another rule is better in other situations. But the market monetarist view is that interest rate or inflation targeting (or even a Taylor rule) is never better than level targetting. A rate target, if it is always applied correctly and never deviated from, might optimally work out the same as a level target. But once deviated from it becomes inferior to a level target, which makes up for prior mistakes. Furthermore, many popular targets do not distinguish between supply and demand. An inflation target treats a negative supply shock and a positive demand shock the same. A nominal GDP target has an opposite reaction to the two. That's why its advocates think it is always superior. I had not heard of Woodford & Eggertson's optimal policy, but if it is optimal then there is a risk the Fed might switch to it. But you don't seem to find that very likely!

When I asked you about this in an earlier post, you claimed helicopter drops were fiscal policy. Now it's 'coordinated monetary-fiscal policy'.

'Basically, the Treasury borrows money, writes checks to voters ("helicpoters"), and the Fed buys the debt.'

Isn't it, the Treasury issues bonds, the Fed buys them with bookkeeping entries, the Treasury somehow transforms those entries into currency and then showers that from helicopters which--like the gentle rain from heaven--falls on the voters and non-voters alike?

Then, what prevents the lucky recipients from spending the money and stimulating GDP? Surely not low interest rates.

So the Fed is powerless, but it would also be nice to hear about the negative consequences of QE and the Fed's commitment to keep rates low.

It seems like there is a real-options story. Businesses and banks have many reasons to postpone investment until volatility decreases. A cost of waiting, however, is that financing rates could jump away from their historic lows today. The fear of higher future rates could induce investment today (assuming the higher rate is not strongly correlated with the project's profitability).

So even if the Fed could commit to lower rates in the future, it is not clearly a good idea if it delays investment.

First, the Fed's normal policy responses to a lack of AD are not possible in the zero-bound world we live in today (pushing on the string). So all we are left with is the Fed accommodating fiscal policy by buying up huge amounts of government debt which allows the government to spend at a lower intertemporal cost. That seems to be what Woodford is advocating. What really strikes me about Woodford's policy prescription is that it completely ignores the micro issues of resource allocation. Is a "helicopter dump" via the Federal government an efficient (effective?) way to allocate resources? My reading of the evidence is that governments are pretty bad at such allocations (Solyndra?). But it seems that Woodford believes such allocation/efficiency issues are unimportant to the Macro economy (at least in the current environment). Is what we need just an AD increase regardless of the distributional issues? Aren't the distributional issues at the heart of the New Keynesian paradigm? Isn't that why frictions and adjustment costs at the micro level have important impacts at the macro level? Is the so-called spending multiplier not a function of allocation/efficiency at the micro level?

The other issue that troubles me is the idea that inflation right now is an unambiguously good thing. Creating some inflation may have some beneficial effects on the economy but it surely is not through increasing AD, at least not directly through the normal liquidity/credit channels. One of these potentially beneficial effects of higher inflation is the reduction in real debt burdens, especially mortgage debt. But it should be clear to the readers/posters on this site that such an outcome is simply a wealth transfer from creditors to debtors. Is this benefit worth the associated costs? I don't know the answer, but it seems an important question to answer before we implement the policy.

Mike recognizes, as I do, that the Fed can do nothing more to raise nominal GDP today. Rates are at zero. The Fed has did what it could. The trend line was not achievable.

Bill Woolsey replies:

Here is the relevant section of Woodford's paper:

Standard New Keynesian models imply that a higher level of expected real incomeor inflation in the future creates incentives for greater real expenditure and larger price increases now; but in the case of a conventional interest-rate reaction function for the central bank, short-term interest rates should increase, and the disincentive that this provides to current expenditure will attenuate (without completely eliminating) the sensitivity of current conditions to expectations. If nominal interest rates instead remain unchanged, the degree to which higher expected real income and inflation later produce higher real income and inflation now is amplified. If the situation is expected to persist for a period of time, the degree of amplification should increase exponentially. Hence it is precisely when the interest-rate lower bound is expected to be a binding constraint for some time to come that expectations about the conduct of policy after the constraint ceases to bind should have a particularly large effect on current economic conditions

The Fed being powerless to create inflation would be a tremendous boon, if it were true. They could buy and cancel the entire national debt without inflation budging! For better or worse, expected inflation does increase when the Fed does QE, even during "liquidity traps".

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!